DeLeo, Deputy Director of the Conservatorship Division of the Federal Housing
Finance Agency (FHFA) told a Senate Banking Committee hearing that the new
profitability of Freddie Mac and Fannie Mae (the GSEs) "should not blind us to
the very real costs associated with their failures." The dividends the two have paid to the
Treasury, she said, reflect not a return of capital, but payment for the
extraordinary risk the government was forced to take in saving them.
is in keeping with FHFA's responsibilities as conservator to minimize taxpayer
risks while ensuring the operation of the secondary mortgage market. "At the same time, standards, norms, and
private investment capacities are needed that can continue under a new
secondary market structure," she said. "Credit
risk transfers can help us simultaneously in all three of our broad
conservatorship goals: build, contract, and maintain," and accordingly FHFA has
set a target for each of the GSEs to carry out a minimum of $30 billion in risk
sharing transactions this year.
initial focus has been on two broad categories of risk sharing, pre-funded
capital markets transactions, and insurance or guarantee agreements. The former includes Freddie Mac's Structured
Agency Credit Risk securities (STACRs) and Fannie Mae's Connecticut Avenue
Securities (C-deals) under which investors buy debt securities that offer relatively
higher returns when credit performance is good but may lose principal when
credit performance deteriorates. The insurance or guarantee agreements are ones
in which an insurer pays claims in the event of loss.
both types of transactions, the Enterprises essentially use a portion of their
guarantee fee income from the reference pool to purchase credit protection,
either through higher interest rates paid on the capital market transactions,
or though premiums paid to insurance companies.
year, each GSE has sold debt securities that transfer to private investors a
portion of the credit risk of a large reference pool of single-family mortgages
that the Enterprise had previously securitized.
Freddie Mac has completed two STACR transactions to date, and Fannie
has completed one C-deal. Each
transaction provides credit protection to the issuing GSE by reducing the principal
on the debt securities as credit performance of the reference pool
the STACRs and C-deal were issued as senior debt of Fannie Mae or Freddie Mac
and investors can rely on the GSEs' special credit standing and the backing of
the Treasury as comfort the payments to investors will occur. But part of the
purpose of these transactions is to develop standardized credit risk investments
that could be sold in the future by securitizers other than the GSEs.
The GSEs ultimately hope to issue notes through
bankruptcy remote trusts that would have the same economics for investors, but
a legal structure independent from the GSEs credit standing, relying on the
trust managing the proceeds from the note. This eventuality has raised a number
of questions that FHFA is working with other agencies to resolve but statutory
clarifications might be helpful. DeLeo
said FHFA is working with the Committee staff on possible solutions. She noted
that all of these structures would be ineligible for REMIC tax treatment but obtaining
that treatment would significantly expand the investor base.
Enterprises have also completed insurance transactions this year as well. In October Fannie Mae executed a pool
insurance policy with National Mortgage Insurance (National MI) which
transferred a substantial portion of the credit risk on a pool of single-family
mortgages securitized by the Enterprise in the fourth quarter of 2012. In
November Freddie Mac executed a transaction that transferred to Arch
Reinsurance, a global reinsurer, a portion of the residual credit risk that the
Enterprise had retained on the reference pool of mortgages underlying the first
of the risk transfer models under which the GSEs have executed transactions has
inherent strengths and weaknesses. From
a GSE perspective, the sale of securities provides upfront funding of credit
risk without the counterparty risk inherent in transferring credit risk. This approach offers efficient, competitive,
market pricing of risk, spreads risk across many investors with varying degrees
of leverage, and with varying degrees of risk concentration in mortgages. A possible downside is that overreliance on
this approach may leave the market for risk more prone to price change in
response to changing market conditions.
an overall housing finance system perspective, the leverage of participating
investors in capital markets transactions may not be regulated, presenting significant
variation in the amount of equity capital deployed to bear credit risk and capital
markets funding sources maybe more volatile over the credit cycle. Transferring risk to the insurance sector
allows for monitoring of financial strength and leverage either by the market
or through regulatory requirements. The
potential differences in the leverage under the two models also have
implications for their relative cost.
FHFA and the Enterprises will continue to assess those strengths and weaknesses,
reinsurance the GSEs can take advantage of the firms' mortgage expertise and
dedicated capital and they may be less quick to leave the market during a
temporary market disturbance, especially one not directly related to housing markets.
However, this approach involves more
counterparty risk, more vulnerability to housing market weakness when the counterparties
are not diversified, and a more limited set of bidders for the risk.
potentially powerful means of risk transfer is use of senior/subordinate
security structures. The GSEs have made
progress in considering how such structures might work and are grappling with
many of the problems faced by private label securities issuers such as: due
diligence, representations and warranties, dispute resolution, and the role of
trustees. If good solutions can be found for past problems, this approach may
be easier than some others for non-GSE issuers to adopt. A disadvantage to
transferring losses on a small pool of mortgages in a cash transaction, rather
than on a large reference pool in a synthetic transaction or insurance agreement, is that credit evaluation
costs can be considerably higher, as investors must consider the idiosyncratic
risks of a particular small pool, rather than those of a cohort diversified
lender, and sheer size. Considering ways to develop more standardization and liquidity in this market
could help to address some of these issues.
The transactions considered so far have been GSE-centric
in that they depend
heavily on the GSE's existing business
practices and the familiarity of loan sellers
and investors with those practices.
There is a need to make these advantages more generalizable such as by
arranging for credit enhancements or by outsourcing servicing and loss
mitigation to firms specializing in those activities.
DeLeo said the GSEs have made major
steps in risk transfer
this year and, if sufficiently scalable,
they will provide mechanisms to free
taxpayers from shouldering almost all the
burden of mortgage credit risk and place
that risk in the private
sector. FHFA will, she said, continue
with the GSEs to explore new
techniques or variations to
find the most workable
solutions and those that show the best promise of reducing the GSEs' footprint,
consistent with maintaining efficient and effective